Tech Stocks' Rapid Rise Draws Some Concern

Fueled by an excitement for new gadgets, new services and a positive outlook for this year’s holiday retail season, shares of Amazon.com (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Netflix (NASDAQ:NFLX), among others, have hit all-time highs.

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Notably, Amazon is trading at levels not seen since the 2000 dotcom bubble on a split-adjusted basis – a small victory for those shareholders who may have held onto their shares for the past decade.

In part, Apple, Amazon and Netflix have shot up this year as consumers begin to more broadly embrace Internet-delivered content and mobile devices as evidenced by Amazon’s Kindle, the iPad, and streaming movie content via Netflix. Apple has sold millions of iPads since the tablet computer’s launch in April, while Netflix has been buoyed by the effective demise of its main competitor, Blockbuster, and the company is now trying to get into the much-more competitive stream video space.

With that rising investor enthusiasm comes rising worries that expectations might be overblown. Amazon.com is now trading at roughly 70 times earnings on a 12 month trailing basis, Netflix is trading at roughly 80 times earnings and Salesforce.com is trading at an obscene 260 times earnings.

This is in comparison to Apple which, while trading near all-time highs of $320 per share, is valued at roughly 22 times earnings.

A price-to-earnings ratio is how much a company’s stock is valued versus how much a company earns on an annual basis. While a simple metric, it’s used by investors to show when a stock price may have currently outpaced a company’s earnings potential.

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“The higher a PE-ratio becomes, the more room is there for a fall because so much is built into a company’s stock at that point,” said Daniel Morgan, portfolio manager with Synovus Trust Co. and a long-time investor in technology.

“If you’re holding a dominant niche in this sector like an Amazon or an Apple, then you’ll do well,” said Keith Goddard, co-portfolio manager of the Capital Advisors Growth Fund, which invests in growth stocks like Google (NASDAQ:GOOG) and Apple.

While the prospects are good for tech, Goddard and other investors feel names like Amazon.com and Netflix have gotten ahead of themselves in price. Morgan said new devices like Amazon’s Kindle or Netflix’s move into streaming services can make investors excited when in the end those products mean little to a company’s current earnings potential.

In the case of Netflix, while streaming content is a much higher margin business than traditional physical media, the company is now going up against the much-larger Hulu and Apple.

S&P equity analyst Michael Souers covers both Netflix and Amazon, and has a “sell” and “hold” rating on each, respectively. Souers said that while both companies have “magnificent” businesses, the math simply wasn’t working.

Souers is more comfortable with Amazon because of the medium- to longer-term story of consumers migrating to online shopping and because Amazon is exposed to the much-larger retail industry.

“But both companies’ share have run up so much,” he said. “In order to justify these valuations you’re leaving little room for error down the road.”

Souers had a “buy” rating on Amazon as late as September. Goldman Sachs (NYSE:GS) also pulled Amazon from its “conviction buy” list around the same time.

Synovus’ Morgan says he continues to like tech broadly, but says the run up in some names gives the sector “patchiness” and he continues to favor the more traditional names like Cisco (NASDAQ:CSCO), IBM (NYSE:IBM) and Apple which, while not necessarily market boomers, are trading at more reasonable multiples in the sector.